Macroeconomics

First Report on the Public Credit, which he presented to Congress in 1790, he wrote:

If the maintenance of public credit, then, be truly so important, the next inquiry

which suggests itself is: By what means is it to be effected? The ready answer to

which question is, by good faith; by a punctual performance of contracts. States,

like individuals, who observe their engagements are respected and trusted, while

the reverse is the fate of those who pursue an opposite conduct.

Thus, Hamilton proposed that the nation make a commitment to the policy rule

of honoring its debts.

The policy rule that Hamilton originally proposed has continued for more

than two centuries. Today, unlike in Hamilton’s time, when Congress debates

spending priorities, no one seriously proposes defaulting on the public debt as a

way to reduce taxes. In the case of public debt, everyone now agrees that the gov-

ernment should be committed to a fixed policy rule. 

■

CASE STUDY

---

Rules for Monetary Policy

Even if we are convinced that policy rules are superior to discretion, the debate

over macroeconomic policy is not over. If the Fed were to commit to a rule for

monetary policy, what rule should it choose? Let’s discuss briefly three policy

rules that various economists advocate.

Some economists, called monetarists, advocate that the Fed keep the

money supply growing at a steady rate. The quotation at the beginning of this

chapter from Milton Friedman—the most famous monetarist—exemplifies this

view of monetary policy. Monetarists believe that fluctuations in the money

supply are responsible for most large fluctuations in the economy. They argue

that slow and steady growth in the money supply would yield stable output,

employment, and prices.

A monetarist policy rule might have prevented many of the economic fluctu-

ations we have experienced historically, but most economists believe that it is not

the best possible policy rule. Steady growth in the money supply stabilizes aggre-

gate demand only if the velocity of money is stable. But sometimes the econo-

my experiences shocks, such as shifts in money demand, that cause velocity to be

unstable. Most economists believe that a policy rule needs to allow the money

supply to adjust to various shocks to the economy.

A second policy rule that economists widely advocate is nominal GDP tar-

geting. Under this rule, the Fed announces a planned path for nominal GDP.

If nominal GDP rises above the target, the Fed reduces money growth to

dampen aggregate demand. If it falls below the target, the Fed raises money

growth to stimulate aggregate demand. Because a nominal GDP target allows

monetary policy to adjust to changes in the velocity of money, most econo-

mists believe it would lead to greater stability in output and prices than a mon-

etarist policy rule.

A third policy rule that is often advocated is inflation targeting. Under this

rule, the Fed would announce a target for the inflation rate (usually a low one)

and then adjust the money supply when the actual inflation rate deviates from

the target. Like nominal GDP targeting, inflation targeting insulates the econo-

my from changes in the velocity of money. In addition, an inflation target has the

political advantage of being easy to explain to the public.

Notice that all these rules are expressed in terms of some nominal vari-

able—the money supply, nominal GDP, or the price level. One can also imag-

ine policy rules expressed in terms of real variables. For example, the Fed

might try to target the unemployment rate at 5 percent. The problem with

such a rule is that no one knows exactly what the natural rate of unemploy-

ment is. If the Fed chose a target for the unemployment rate below the nat-

ural rate, the result would be accelerating inflation. Conversely, if the Fed

chose a target for the unemployment rate above the natural rate, the result

would be accelerating deflation. For this reason, economists rarely advocate

rules for monetary policy expressed solely in terms of real variables, even

though real variables such as unemployment and real GDP are the best mea-

sures of economic performance.

C H A P T E R   1 5

Stabilization Policy

| 457

---

458

|

P A R T   V

Macroeconomic Policy Debates

Inflation Targeting: Rule or 

Constrained Discretion?

Since the late 1980s, many of the world’s central banks—including those of Aus-

tralia, Canada, Finland, Israel, New Zealand, Spain, Sweden, and the United King-

dom—have adopted some form of inflation targeting. Sometimes inflation

targeting takes the form of a central bank announcing its policy intentions. At

other times it takes the form of a national law that spells out the goals of mone-

tary policy. For example, the Reserve Bank of New Zealand Act of 1989 told the

central bank “to formulate and implement monetary policy directed to the eco-

nomic objective of achieving and maintaining stability in the general level of

prices.” The act conspicuously omitted any mention of any other competing

objective, such as stability in output, employment, interest rates, or exchange rates.

Should we interpret inflation targeting as a type of precommitment to a pol-

icy rule? Not completely. In all the countries that have adopted inflation target-

ing, central banks are left with a fair amount of discretion. Inflation targets are

usually set as a range—an inflation rate of 1 to 3 percent, for instance—rather

than a particular number. Thus, the central bank can choose where in the range

it wants to be: it can stimulate the economy and be near the top of the range or

dampen the economy and be near the bottom. In addition, the central bank is

sometimes allowed to adjust its target for inflation, at least temporarily, if some

exogenous event (such as an easily identified supply shock) pushes inflation out-

side of the range that was previously announced.

In light of this flexibility, what is the purpose of inflation targeting? Although

inflation targeting leaves the central bank with some discretion, the policy does

constrain how this discretion is used. When a central bank is told simply to “do

the right thing,” it is hard to hold the central bank accountable, because people

can argue forever about what the right thing is in any specific circumstance. By

contrast, when a central bank has announced a specific inflation target, or even a

target range, the public can more easily judge whether the central bank is meet-

ing its objectives. Thus, although inflation targeting does not tie the hands of the

central bank, it does increase the transparency of monetary policy and, by doing

so, makes central bankers more accountable for their actions.

The Federal Reserve has not adopted an explicit policy of inflation targeting

(although some commentators have suggested that it is, implicitly, targeting infla-

tion at about 2 percent). One prominent advocate of inflation targeting is Ben

Bernanke, a former professor of economics whom President Bush appointed to

succeed Alan Greenspan as chairman of the Federal Reserve. Bernanke took over

the job in 2006. In the future, the Federal Reserve may move toward inflation

targeting as the explicit framework for monetary policy.

5

■

CASE STUDY

5

See Ben S. Bernanke and Frederic S. Mishkin, “Inflation Targeting: A New Framework for Mon-

etary Policy?” Journal of Economic Perspectives 11 (Spring 1997): 97–116.

---

C H A P T E R   1 5

Stabilization Policy

| 459

Central-Bank Independence

Suppose you were put in charge of writing the constitution and laws for a

country. Would you give the president of the country authority over the poli-

cies of the central bank? Or would you allow the central bank to make deci-

sions free from such political influence? In other words, assuming that

monetary policy is made by discretion rather than by rule, who should exer-

cise that discretion?

Countries vary greatly in how they choose to answer this question. In some

countries, the central bank is a branch of the government; in others, the central

bank is largely independent. In the United States, Fed governors are appointed

by the president for 14-year terms, and they cannot be recalled if the president

is unhappy with their decisions. This institutional structure gives the Fed a

degree of independence similar to that of the U.S. Supreme Court.

Many researchers have investigated the effects of constitutional design on

monetary policy. They have examined the laws of different countries to con-

struct an index of central-bank independence. This index is based on various

characteristics, such as the length of bankers’ terms, the role of government offi-

cials on the bank board, and the frequency of contact between the government

and the central bank. The researchers then examined the correlation between

central-bank independence and macroeconomic performance.

The results of these studies are striking: more independent central banks are

strongly associated with lower and more stable inflation. Figure 15-2 shows a

scatterplot of central-bank independence and average inflation for the period

1955 to 1988. Countries that had an independent central bank, such as Germany,

Switzerland, and the United States, tended to have low average inflation. Coun-

tries that had central banks with less independence, such as New Zealand and

Spain, tended to have higher average inflation.

Researchers have also found that there is no relationship between central-

bank independence and real economic activity. In particular, central-bank inde-

pendence is not correlated with average unemployment, the volatility of

unemployment, the average growth of real GDP, or the volatility of real GDP.

Central-bank independence appears to offer countries a free lunch: it has the

benefit of lower inflation without any apparent cost. This finding has led some

countries, such as New Zealand, to rewrite their laws to give their central banks

greater independence.

6

■

CASE STUDY

6

For a more complete presentation of these findings and references to the large literature on cen-

tral-bank independence, see Alberto Alesina and Lawrence H. Summers, “Central Bank Indepen-

dence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit,